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2What is strategic asset allocation?The efficient optimisation of investment allocation to major asset classes of investment in order:- to meet the overall investment objectives of the institution and- to achieve an acceptable balance between risk and return

3As opposed to tactical investment selectionTactical investment selection is the choice of individual investments in line with the chosen strategyBoth strategic and tactical decisions are importantBut the strategy will often be the more significant determinant of performance

5Also …. provide source of government fundingprovide finance for specific government investment projects or to further government policydevelop capital markets

6General principles assets should be appropriate to the liabilitiesdiversification is needed to reduce risk……between asset classes and within classestrade-off of risk and returncorrelations of risks and returns

7Classical asset allocation theoryoptimisation of risk and return (Markowitz)there is a wide spectrum of possible portfoliosrational investors select strategy on frontier……to maximise return for given level of risk……or to minimise risk for given level of returncombine portfolio with risk-free assets to reflect acceptable level of riskassumes asset returns are known and normally distributed

9However this approach is simplisticreturns are not normally distributed and variance is not the only measure of riskthe returns, variances and correlations are not known, and may change over timedoes not have regard to the liabilities

10Liabilities investments aim to allow the liabilities to be metsome more uncertain than otherspromise to pensions or other cash benefits in futurepromise to provide non-cash benefits such as healthcarecontingent liabilities, including catastrophe and fluctuation reserves

11Nature of liabilitiesidentify the liabilities to which the investments relateamount and timingnominal or related to inflationcurrencydegree of uncertainty in amount and timingpossible embedded options

16Matching the assets and liabilitiesmatching involves investing in instruments whose value will behave in a similar way to the value of the liabilities in varying financial conditionsif absolute matching, no future changes in conditions would affect the ability to meet the liabilitiesin practice, matching will never be absolutematching may be low risk, but may be expensive if the matching assets have low returns

17Example of matchingthere may be a liability to pay pensions, increasing in line with prices, to an existing group of pensionersthe pensions in effect represent a stream of payments linked to prices over the next 30 years or soindex-linked government bonds also represent a stream payments linked to priceshence matching could be achieved by investing in a portfolio of index-linked bonds whose duration was similar to that of the pensions

19Example of matchingin practice, the position may be much more complicated than thisliabilities will also relate to current workers and their benefits may therefore depend on wage as well as price inflationthe scheme may be only partially funded raising the question of which liabilities are funded and can be matchedfuture contributions might be regarded offsetting future payments but this adds further uncertainty

20Asset-liability modellingdetermine the measure to be controlled by the investment policy, e.g. the funding level (assets as a percentage of liabilities) or contribution ratestochastically project liabilities and assetsmany different investment models and parameters which will produce differing resultscompare results from different strategic asset allocations

22Suitability of asset classesCash and short-term depositsusually low risk and low returnuseful for liquidity (e.g. for a working balance and fluctuation reserves)not generally appropriate for longer duration liabilities except as a short-term tactical measure

23Suitability of asset classesGovernment bondsa variety of terms means they are often useful as matches for certain liabilitieslonger-term bonds can be vulnerable to high inflation and therefore index-linked bonds may be preferred if liabilities are inflation linkedmay be relatively marketable, although this will depend on the country concernedgenerally low risk and low return

24Suitability of asset classesCorporate bondssimilar to government bonds but less secure (and consequently higher return)risk will vary according to the issuer and may change during the course of the investmentmarket for corporate bonds usually less broad and less liquid than that for government bondswill be affected by wider economic sentiment and may therefore have depressed values at precisely the time they are needed (e.g. in a recession)

25Suitability of asset classesEquitiesmore risk and higher expected returns than bondshistorically have produced considerably higher returns than bondsreturns should be linked to future economic fortunes of the countryhowever, the value of equities can vary very widely in the short and long-termhigh levels of equity investment may lead to issues of government control and indirect nationalisationmarket in equities may be limited or non-existent in some countries

26Suitability of asset classesForeign investmentuseful in order to diversifycan take advantage of investments not available in the domestic marketmay introduce currency mis-matches which can be mitigated by suitable hedgingcentral banks may be concerned over possible adverse currency flowstax may be levied in foreign countries

27Suitability of asset classesReal estatesome features of bonds and equitiesgenerally illiquid and expenses of managing such investments can be highinvestment in domestic property (houses) may be sensitive and prone to political interference

28Benchmarking set a benchmark against which to measure performancebenchmark might be a low risk matching portfolio……or perhaps an index or combination thereofeffect of deviating from the benchmark can be measuredis the extra return worth the risk?